RDP 9409: Default Risk and Derivatives: An Empirical Analysis of Bilateral Netting 1. Introduction

Bilateral netting is an arrangement that allows amounts owing between two counterparties to be combined into a single net figure payable from one to the other. Of greatest interest to supervisors is the potential offered by bilateral netting to reduce credit risk arising from banks' derivative transactions.

In the absence of a netting arrangement, a bank would examine each single contract with a counterparty and measure its credit exposure as the sum of the figures owing to it. That amount would represent the maximum loss that would be incurred should the counterparty fail. The alternative is where a bank nets the results of its individual transactions with a counterparty, setting off its obligations to its counterparty against sums owing to it. In theory, once an appropriate netting agreement is in place, the total amount owed by the bank, and owed to it in relation to a single counterparty, could be represented as a single figure which, in the event of failure by either party, becomes the amount due and payable.

The current capital adequacy standards applying to banks set out a method of calculating the minimum amount of capital that must be held to cover the risk of counterparty default on both on and off balance sheet activities of banks (including their derivative transactions). In determining that minimum capital level, a fairly restrictive form of netting is recognised – netting by novation.^[1] Under that arrangement, only contracts between counterparties that are settled in the same currency and on the same date can be netted. The effect is to reduce exposure to credit loss and thus reduce required capital.

In line with the rapid growth in banks' derivative and market-related transactions over the late 1980s, interest of both market practitioners and of supervisors has turned to ways in which expanded and more effective netting agreements can be devised to reduce banks' credit exposure to counterparties by amounts greater than can be achieved through existing methods. The particular focus has been “close-out” netting. Such an arrangement typically involves the use of a master agreement in which all contracts with a single counterparty, covering all maturity dates, are included. The market value of the portfolio can be calculated by evaluating the present value of positive and negative cash flows associated with all contracts and the net result becomes the amount which, in the event of counterparty default, would be owed by one to the other. Because of the range of potential contracts captured under such an arrangement, the reduction in capital arising from close-out netting could be considerable compared with current practice.

The inclusion of extended netting arrangements into capital adequacy calculations hinges on two factors, one legal, one technical:

• the legal issue is the extent to which such close-out netting contracts are enforceable at law. In some countries Corporations or Bankruptcy laws effectively prevent such arrangements by including provisions which give liquidators of failed companies the right to “walk-away” from particular contracts (typically those which involve payments to counterparties). Where such laws exist, close-out netting would have little meaning since, for the failed company, only favourable contracts would be recognised. A great deal of effort has been devoted, in a number of countries, to clarifying the law relating to netting; ^[2] and
• the second, and more technical question, comes after the legal issues have been resolved. It has to do with the method used to calculate the capital charge on a netted derivative portfolio.

This paper focuses on the second of those issues.

The starting point is a proposal issued by the Basle Committee on Banking Supervision in April 1993 which envisages an extension of current netting arrangements to capture close-out netting. It sets out a particular method for calculating a capital charge on a netted derivative portfolio. The charge is based on a measure of total credit exposure of a portfolio calculated as the sum of the net mark-to-market value of the portfolio and an “add-on”, or additional capital charge, to account for potential or future credit exposure. In its present form, the add-on component is measured as a proportion of the total notional value of each transaction. Some market participants have argued that the approach, particularly in regard to the calculation of the add-on, is excessively conservative and leads to a capital charge that is too high relative to the true risks faced by banks.

The difficulty is that the appropriate methodology for setting a capital charge cannot be determined solely on intuitive grounds. Current credit exposure should fall as a result of netting, so long as a counterparty's contracts are not all on one side of the market (the magnitude of any reduction being dependent upon the extent to which negatively valued contracts are out-of-the-money).^[3] However, the effect of moving from a non-netting to a netting environment on potential exposure is less clear. To the extent that the market values of contracts within a portfolio are negatively correlated, movements in those values will tend to be offsetting, thus reducing the potential for the portfolio to increase in value and thus reducing future exposure. On that basis, it would seem appropriate to adopt an add-on formulation which reflects that fact.

It is possible, however, that in moving from a non-netting to a netting environment, total credit exposure (current plus potential) may fall by less than the reduction in current exposure. There is nothing which strictly links the current value of a portfolio and the variability of that portfolio. The gap between current exposure and total exposure, which must be covered by the potential exposure add-on may, therefore, increase.

In seeking to cover the exposure associated with any portfolio, it would be possible to base a capital charge on any variable, provided the multiplier is high enough. Determining an appropriate base for a capital charge, however, is about more than absolute coverage. It is a matter of specifying a charge which covers exposure under all likely circumstances and does so with an efficient allocation of capital. The search, then, is for a base that is reasonably strongly correlated with a portfolio's exposure.

In this paper, the efficiency and coverage of alternative capital charges are tested by regressing them against a more sophisticated measure of credit risk. The tests are performed using portfolios of interest rate swaps and forward rate agreements obtained from Australian banks.

The next section describes interest rate swaps – the financial product on which our empirical results are based. Section 3 sets out a method for determining credit exposure employing interest rate simulations. It is this measure of credit exposure which is used as a benchmark against which the performance of the various capital charges is compared. Section 4 discusses, from an intuitive perspective, the impact of moving from a non-netting to a netting environment on the credit risk of a bank's swap portfolio. Section 5 provides a description of the current capital adequacy arrangements and a number of approaches that have been put forward as possible alternatives. The results of testing the performance of the current calculation method and the alternative methods are presented in Section 6. Section 7 presents evidence on the rescaling of capital charge add-ons required to reflect the change in potential exposure resulting from a move to a netting environment. Concluding comments are in Section 8.

Footnotes

Netting by novation commonly refers to a master contract between two counterparties under which any obligation between the parties to deliver a given currency on a given date is automatically amalgamated with all other obligations under the agreement for the same currency and value date. The result is to legally substitute a single net amount for the previous gross obligations. [1]

In the US, for example, special legislation has been enacted to give broad legal effect to netting arrangements. [2]

A bank holding a contract with a positive mark-to-market value is “in-the-money”, that is, it would have the right to receive payment from the counterparty if the contract were terminated. A bank holding a contract with negative mark-to-market value is “out-of-the-money” on that contract, that is, the bank is under an obligation to pay the counterparty. [3]